Takeaway:We expect an extension of the production cuts for another six months & Russia to get a pass on compliance

Editor's Note: Below is a complimentary excerpt from a recent research note written by our Energy Policy analyst Joe McMonigle. For more information on our institutional research email sales@hedgeye.com.

Amid bearish sentiment in oil markets, OPEC seems poised to extend its production cut deal for another six months with its non-OPEC partners at the group’s next meeting in a few weeks. In our view, a rollover of the production cuts is the likely outcome.

In addition to a rollover of production cuts, the meeting itself could see a rollover. OPEC+ is scheduled to meet on June 26-27 in Vienna but Russia wants to move it to July 3-4, citing a scheduling conflict with the G20 meeting. The Saudis, eager to keep Russia in the OPEC deal, support the date change but others ministers, most notably Iran, are opposed.

A potential compromise being discussed is for OPEC ministers-only to meet on June 26 and move the non-OPEC meeting to July 3 or 4 – a delay that could complicate messaging and potentially create some additional volatility in oil markets.

Saudi Energy Minister Khalid al-Falih concluded a 5-day trip to Russia on Monday that was ostensibly all about getting Russia on board with extending the production cuts through H2 2019.

While al-Falih pronounced the rollover was “in the bag for OPEC,” he also acknowledged the possibility “to calibrate with the non-OPEC side to see if there needs to be an adjustment from the first half of the year.”

To be clear, the carefully chosen words “calibrate” and “adjustment” refers to a potential concession to Russian energy companies opposed to an extension due to concerns about losing market share to surging US production.

We wrote a note in March about Russian resistance to continuing the OPEC+ cuts and said “we think Russia will increasingly be a reluctant partner in future cuts.”

But the Saudis view Russia’s participation in the production cut deal as critical to shoring up market sentiment. Certainly, a Russian exit from the OPEC+ deal would be very bearish for oil prices even if OPEC itself continues the cuts. In messaging targeting Russian oil companies, both al-Falih and Russia Energy Minister Alexander Novak publicly forecasted $30 oil prices on Monday if the cuts are not extended.

It was also announced on Monday that President Putin would make a visit to Saudi Arabia in October. We think it’s unlikely this announcement would have been made without Russia’s agreement to extending the cuts at least in principle.

In our view, we see a tacit agreement from a practical standpoint that will give Russia a pass on compliance to mollify opposition from Russian producers. It’s a win-win: Saudis get the press release with Russia approving the rollover of cuts for market sentiment but Russian producers get to hike production.

Macro factors combined with recent increases in US crude inventories and rising light crude production are responsible for the latest downturn in oil prices. In our view, we think fundamentals are strong for a tight oil market, especially as refiners come back online after a longer than normal seasonal maintenance and growing geopolitical risks.

As a result, we may see OPEC actually encourage non-compliance in the fall just as OPEC begins to report compliance data by country.

OPEC messaging at the June and/or July meetings will be critical for market sentiment. We think having two separate meetings will present a challenge to effective communications to the market. But we also see the possibility that it could give OPEC a bigger megaphone to highlight production cuts amid trade tensions and concerns about the global economy.

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